Updated: Feb 21, 2022
As of Dec 2021, Feds have signaled three rate hikes in 2022 with the first hike as early as March and that they end the pandemic era bond purchases in March, paving the way for 0.75% rate hike by 2022FYE. BoC is expected to raise interest rates before US Feds, keeping inflation target at 2%, with Canadian inflation expectation remaining high at 4.7% in the near term. BoE raised its key interest rate to 0.5%, saying it expected annual inflation to accelerate above 7% within months. ECB is expected to follow suit shortly. The spread between the 10-yr treasury rates and TIPS rate, a proxy for expected inflation, stood at 2.48% as of Jan 31, 2022.
The yield curve moved all over the place in 2021 with short-dated treasury yields advancing more relative to longer dated treasuries. 3-month yields remained relatively flat and 1 yr yield experienced the highest increase; 30 yr yields experienced the lowest increase. Hence, rates rose across all maturities, but shorter terms rates rose more than longer term maturities throughout the year.
Consequently, the 30 yr – 10 yr yield spread curve flattened during 2021. The US Treasury has indicated that it would cut coupon issuance across all maturities in Q1/22 with the largest cut in the 7 yr and 20 yr maturities.
Despite the decline in the pace of economic growth due to supply chain bottle necks and heightened inflation, a rise in interest rates due to an increase in real growth as opposed to a rise in inflation has a positive impact on public equities. With monetary velocity as indicated by the ratio of nominal GDP to M2 money supply at record lows, there is plenty of liquidity in the market to fund GDP growth in 2022.
 Inflation will determine much of the investing methodologies and stock selection decisions in 2022. The outlook for inflation and the expectation of how it will playout throughout 2022 impact asset allocation decisions. Inflation can be measured in a variety of ways including the net change in CPI, PPI and the GDP deflator. All measures point to heightened inflation throughout 2021 and into 2022.
The expectation for inflation will drive many investment decisions this year. This expectation can be determined in a variety of ways including through surveys or the spread between the treasury bond rates and inflation protected treasury bond rates of equivalent maturity. Hence, expected inflation is predictable and it can be integrated into stock selection, investing and asset allocation decisions with investors requiring higher rates on bonds or higher expected returns for stocks. The unexpected inflation, however, which is the difference between the actual inflation and the expected inflation, will impact investors and businesses with or without pricing powers and asset classes such as equities, bonds, currencies and real assets differently. In the following calculations the expected inflation is determined by taking the average inflation rate over the last 10 years. The unexpected inflation data along with all asset data (equities, bonds, gold, treasuries) are then broken down into five quintiles with the lowest quintile representing a scenario when actual inflation is below the expected inflation at most and highest quintile representing the scenario when actual inflation is above the expected inflation at most.
Inflation & Financial Assets
Looking at the impact of unexpected inflation over the last 60 years (1961 – 2021) on stock returns (indicated by S&P 500 annual returns) and corporate bond real yields (indicated by Moody’s Aaa and Baa Seasoned Corporate Bonds returns), it is evident that in periods when inflation is higher than expected, stocks do worse on nominal and real basis and corporate bonds do worse on a real basis. Hence, inflation is not good for financial assets.
Inflation vs. Size vs. Value/Growth Factors
Looking at the impact of unexpected inflation over the last 65 years (1956 – 2021) on US Small Cap and US Large Cap returns (indicated by Ibbotson® SBBI® US Small-Cap Stocks Less Large-Cap Stocks (Total Return)):
Small Caps have performed better when inflation is higher than expected which represents the return of small cap premium during periods of higher inflation.
Looking at the impact of unexpected inflation over the last 65 years (1956 – 2021) on Value and Growth stocks (indicated by Lowest Decile Less Highest Decile of P/B Stock Returns each year):
Value stocks and low P/B stocks perform better when inflation is higher than expected.
The following charts and tables display the returns of Small Caps relative to Large Caps as well as the returns of value vs. growth stocks during five quintiles of unexpected inflation when inflation is below or above the expected inflation.
Inflation and Gold and Real Estate
Looking at the impact of unexpected inflation over the last 52 years (1969 – 2021) on gold returns (indicated by annual spot gold price change) and real estate return ((indicated by annual real home pricechange):
Real Home Price returns have shown no particular pattern and have remained relatively flat as inflation exceeded expectation.
Gold returns have done much better on a real and nominal basis when inflation is higher than expected. Gold is a bet on inflation and does much better when inflation is higher than expected. Hence, Gold is the best hedge against Unexpected Inflation.
Consequently, if the outlook for 2022 inflation is to remain high with actual values above the expected values, and for high inflation to persist throughout the year, asset allocation should shift away from financial assets and into Gold and real assets, equity allocation should shift toward small caps, low P/B or low P/E ratios and companies with more pricing power; however, if inflation is expected to revert to long term average, like much of 2021, large cap, high growth stocks are expected to outperform despite their high valuation.
Download a comprehensive investment research report of Jan 2022 Review: 2022, A Year of Investing Focused on the Outlook for Inflation by visiting the Basic Modelyze page.
Data in this Blog is sourced from Refinitiv, FRED, Morningstar Direct and Ken French Data Library as of Jan 31, 2022, market close and includes equities listed on North American exchanges.